QE3 - Mortgage Rates And Housing

Over the weekend Paul Krugman discussed that "This [housing recovery] means that we actually can hope that the Fed’s new policy will boost housing as well as operating through other channels, and therefore that it can act more like conventional monetary policy in fostering recovery.” I touched on Bernanke's misunderstanding of QE programs on interest rates in last week's post but Krugman's comments spurred me to go a little bit more in depth about the disconnect that exists between the Fed and Main Street.

In order for QE programs to be effective the liquidity produced by the bond buying program must be moved through the economic system. The chart of excess reserves below clearly shows that the transmission mechanism is broken.

As I wrote last week: "While the most recent bond buying program will push liquidity into the equity markets pushing asset prices higher - it will do little to help the economy, employment or housing. The evidence is abundant that the only beneficiary of these balance sheet programs is Wall Street. As shown in the chart below the average level of excess reserves for banks was roughly $19 billion from 1984 to 2008. Since 2008 excess reserves held at banks has swelled to more than $1.5 trillion currently.

With the consumer weak, unemployment high, foreclosures and delinquencies still burdensome, and businesses constrained by lack of demand - there is little desire, or need, for credit. This is unlikely to change anytime soon as businesses are forced to pullback even more as demand is further reduced by rising inflationary pressures."

When it comes to housing in particular there is even a larger disconnect. Bernanke assumes that by buying mortgage backed bonds out of the market that this will provide an large, and artificial, buyer which will push interest lowers for new mortgages. The thought process is that by lowering mortgage rates individuals will take advantage of the lower rates to buy a home. This premise is flawed.

Interest rates alone are not a motivator of buying a house. Individuals are not sitting around saying "If interest rates were only .25% lower I would buy a house." Take a look at the chart below.

This chart shows a combined index of new and existing home sales. The first take away is that after QE1, QE2, Twist, "cash for houses", HAMP, HARP, foreclosure fraud forgiveness AND THE LOWEST INTEREST RATES IN HISTORY, this is all the housing recovery that could be mustered? The reason is two-fold. First, when the Fed creates excess reserves for the banks - the banks today have a choice. They can either loan money for 30 years to some individual at rates barely above inflation and take on additional default risk OR invest the dollars, through their proprietary trading operations, where returns are dramatically higher. With unemployment high, the economic environment weak and consumer credit remaining an issue - banks are reticent to take on more aggressive lending due to the potential default risk particularly when their books are currently bloated with delinquent loans and pending foreclosures.

As we have discussed extensively before, individuals buy "payments"- not houses. Assume an average American family of four (Ward, June, Wally and The Beaver) are looking for the traditional home with the white picket fence. Since they are the average American family their median family income is approximately $55,000. After taxes, expenses, etc. they realize they can afford roughly a $600 monthly mortgage payment. They contact their realtor and begin shopping for their slice of the "American Dream."

If we assume a stagnant purchase price of $125,000, as interest rates rise from 4% to 8% by 2024 (no particular reason for the date - in 2034 the effect is the same), the cost of the monthly payment for that same priced house rises from $600 a month to more than $900 a month - a 50% increase. However, this is not just a solitary effect. It is not just mortgage payments that go up - prices also come down.

At a 4% interest rate the average American family can afford to purchase a $125,000 home. However, as rates rise that purchasing power quickly diminishes. At 5% they are looking for $111,000 home. As rates rise to 6% it is a $100,000 property and at 7%, just back to 2006 levels mind you, their $600 monthly payment will only purchase a $90,000 shack.

Home prices are affected at the margin by those that are willing, and able, to buy a home versus those that have "For Sale" signs in their front yard. Therefore, if the average American family living on $55,000 a year sees their monthly mortgage payment rise by 50% this is a VERY big issue. As demand dries up - prices of homes began to fall in order to attract buyers.

The problem for Bernanke is that QE programs actually make interest rates rise in the short term as bonds are sold, causing yields to rise, as money is rotated back into the equity market to take on additional risk. The chart below shows the history of QE programs and interest rates.

The chart above shows that when QE programs are engaged that interest rates rise. However, rates fall sharply after the end of QE programs as money rotates out of risk assets back into bonds for safety. If the Fed's goal was really to support the housing market - the best thing to have done would have been "nothing."

The chart also overlays the 30 year mortgage rate over the new and existing home sales composite index. When rates have risen in the past it has slowed sales of homes. This is due to the increases in monthly payments for buyers who are already working on very tight budgets due to stagnant wage growth in recent years. When rates rise potential buyers stop activity to "wait" for rates to fall again. This psychology is what makes deflationary enviroments so hard to break.

While Bernanke and Krugman both want to believe that monetary policy is driving interest rates lower - historical evidence shows that QE programs actually do the opposite. More importantly - if a housing recovery couldn't be started with the lowest mortgage rates in history then what will another quarter point or so actually accomplish? Most likely very little.

The housing problem is not one of monetary policy. Rather it is the story of an economy waged in a deleveraging cycle which is being hampered by a structural shift in employment. Over a decade of declining net worth, stagnant wage growth and rising inflationary pressures continue to choke off household formation. Furthermore, the psychology of home ownership in America's youth has been changed from "buy a house it always goes up in price" to "renting is better."

While Bernanke's latest bond buying program will once again serve to fatten up the profits of Wall Street - for Main Street it will mean rising interest rates, a falling dollar and rising commodity prices. These rising pressures, when overlaid against current economic deflationary backdrop, only ensures that the average American continues to struggle to make ends meet.

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of "Street Talk with Lance Roberts", Chief Editor of "The X-Factor" Investment Newsletter and the Streettalklive daily blog. Follow Lance on Facebook, Twitter and Linked-In